Economics

The Truth About Housing Prices

Separating economic fact from economic myth

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Editor's Note: Reason columnist Veronique de Rugy appears weekly on Bloomberg TV to separate economic fact from economic myth.

Myth 1: In order for the economy to recover, housing prices have to reach pre-recession levels. They cannot decline further. Therefore the government must continue to prop up housing prices or provide incentives to encourage people to buy homes.

Fact 1: Pre-recession housing prices were a historic anomaly based on easy credit caused in part by misguided government policy. Lower housing prices are not bad for everyone. They are also the only way to get rid of our bloated housing inventory.

The idea that economic recovery can't happen unless our housing prices return to pre-recession levels makes no sense.

First, as the chart below shows, for most of American history housing prices grew at a relatively slow rate. It was only in the last 15 years that prices exploded. The factors behind this sudden change are a mixed bag of government policies that encouraged homeownership and cheap interest rates and a willingness by banks to lend to people who could only realistically afford to pay if housing prices doubled every two years. George Mason University economist Russ Roberts has a very good blog post explaining why housing prices went up so fast.

Second, low prices are not bad for everyone. Yes, low prices are bad for homeowners who are trying to sell and for banks that have lots of bad loans on their books. But low prices are very good for people who want to buy houses. They are also very good for low-income buyers who were priced out of the market in recent years. Finally, low prices are good for people who build homes.

But most importantly, only lower prices can address one of the major problems of the real estate market: a bloated inventory of unsold homes.

The inventory of existing homes stood at 3.71 million in November 2010, about where it was four years ago, according to the National Association of Realtors. Add to that the 197,000 new homes for sale and you can see just how bloated the inventory of unsold homes has become.

As Bloomberg's Caroline Baum wrote in January: "The demand curve is downward sloping. What that means is demand for any good or service isn't fixed. It depends on the price. A $1,000 cashmere sweater will find a lot more takers when it's marked down to $500 in a post-Christmas sale. In general, the lower the price, the greater the quantity demanded. Hence, a reduction in prices could address this glut."

We need a reduction, not an increase in prices. A return to the historical norm, not to the recent anomaly. This means that state and federal policies which prop up housing prices are discouraging the market from taking the steps necessary to get back on track.

Myth 2: We need a foreclosure moratorium to help those people drowning in debt who have had to default on their mortgages.

Fact 2: Defaulting on a mortgage does not necessarily reflect an inability to pay. The current crisis has produced a new phenomenon: homeowners who default by choice. A moratorium would eliminate the current penalty and thereby encourage more people who are still able to pay to walk away from their obligations.

While some foreclosures are driven by homeowners' economic hardship, there is much evidence to suggest that many other foreclosures are driven by the homeowners' rational economic calculus.

Economists at the Federal Reserve Bank of Boston conducted research on the borrower's choice to default on a mortgage. Their findings, presented at the 2009 Annual Macroeconomic Conference of the National Bureau of Economic Research, revealed "that 'unaffordable' loans, defined as those with high mortgage payments relative to income at origination, are unlikely to be the main reason that borrowers decide to default." This finding begs further inquiry into the more nuanced homeowner motivations behind the decision to default.

Bankers also created incentives for homeowners to strategically default during the housing boom. Popular lending products—such as low or no-down payment loans and interest-only loans—reduced homeowners' equity investments in their loans. These products allowed consumers to accumulate no equity through their monthly payments. While housing prices were rising, these loans performed exceedingly well, as borrowers could either sell or refinance if they were unable or unwilling to make payments. However, when housing prices turned down, high-LTV loans quickly went underwater, leaving homeowners with strong incentives to permit foreclosure.

Furthermore, there is a very close relationship between the timing of the nationwide drop in housing prices and the rise in the foreclosure rate. The chart below comes from a paper on this topic by George Mason University's Todd Zywicki and Gabriel Okloski called "The Housing Market Crash." On this chart we see the striking relationship between the decline in housing prices and the increase in foreclosure rates. It supports the idea of voluntary homeowner default.

The strong correlation between falling prices (which represent a decrease in homeowners' future return on their investment) and foreclosures suggests that homeowners' anticipated future payoffs, and not simply their current ability to pay, is informing the decision to default.  

As Zywicki explains, while we don't know how many foreclosures are being driven by bad economic fortunes and how many are driven by economic opportunism, we do know that basing policy on the idea that everyone is in the former category creates major moral hazard issues for dealing with those in the latter category.

Myth 3: There is a national foreclosure crisis.

Fact 3: It is a national problem, not a national crisis. It is a crisis in only a handful of states.

Right now there are 2,139,672 foreclosure homes for sale in the United States.

Although home prices have fallen precipitously in many areas of the country and foreclosures have risen to all-time highs, the foreclosure problem in the United States affects states disparately.  

Using data from RealtyTrac, the above heat map compares the foreclosure rates across states in January 2011; the darker the state the more foreclosed properties per housing unit. As you can see, foreclosures are clearly concentrated in certain states. To look at this fact differently, the chart below compares those states with the greatest number of new homes entering foreclosure in January with those with the least number. Once again, there is clearly a large amount of variation in the foreclosure problem facing each state.

As  George Mason's Zywicki wrote to me recently, "one reason that the 'crisis' is concentrated in some states but not others is because of local laws and procedures that make borrower default a relatively more attractive option—such as antideficiency laws that act like a get out of jail free card or long, drawn-out foreclosure proceedings that enable a homeowner to live in their house rent-free for a very long period of time without paying. Think of it this way to illustrate—if defaulting on your mortgage meant that you would have your right hand cut off, then I'd guess you'd see a lot fewer defaults. Easy foreclosure rules increase the option value of default and so more borrowers at the margin do it."

Contributing Editor Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.

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54 responses to “The Truth About Housing Prices

  1. Only three myths, Veronique? You’re slipping. I’m sure that lots of people wish housing prices would go back up to pre-recession prices, but most people know they won’t, not any time soon, and in some places, perhaps, never. As for recovery, it’s already started. I hope you’ve been investing in the stock market, as I have. O that Obama bounce!*

    *This is irony, Matt. But I have to say, this isn’t the recovery of anyone’s dreams.

    1. How have you survived this many years?

      1. Involuntary muscles

    2. m sure that lots of people wish housing prices would go back up to pre-recession prices, but most people know they won’t, not any time soon, and in some places, perhaps, never.

      Want to bet?

    3. “… and in some places, perhaps, never.”

      Don’t worry. Inflation has got this one covered.

  2. it is great that Veronique is speaking truth to a broader audience.

    but I sure hope the people here already knew what she is saying.

  3. What does it mean that a weak housing market is good for people who build houses? You mean like people who want to have a house built from spec with an architect and all that? Because low prices are obviously bad for people in the business of selling houses.

    1. That statement was a mystery to me too.

    2. If prices are low enough that more people can buy a home, then more homes can be sold. Someone has to build them.

      1. Yes, but, if used houses are cheap, then people are less likely to build new ones. I don’t think cheap, used homes (the ones that affect mortgage holders) being inexpensive is good for builders.

        1. So, then, the builders will stop building houses that no one wants to buy and will do something else. That’s one of the functions of price: to help the market (a.k.a. people who own the resources) allocate resources. No crisis or tragedy or anything else. The economy has to adjust from the foolish government policies and the attendant mis-allocation of resources which those policies caused. “We have sown and now it is the season to reap.” Or some quotation like that.

          1. well, builders are building more multifamily units…
            seems there ARE many more renters than buyers…

  4. Congress has the power to make “uniform laws on the subject of bankruptcies throughout the United States.” It seems like they should do something in a situation where the state foreclosure system is so impossible to unf%%k.

    Do the banks want to foreclose on a bunch of way-way underwater houses in the Sun Belt exurbs, thereby admitting how out-of-whack their balance sheets are?

    And how much are lenders going to get back when they are trying to unload a ticky-tack row of particle-board McMansions with weeds sprouting out of the driveway asphalt and big orange “FORECLOSURE” notices stapled to the front doors, anyway?

    1. Danny

      You’re confusing the power of the feds to regulate bankruptcy (a person or corporation being insolvent) and the state powers to regulate real estate law and contracts. The two are distinct. A foreclosure (or Trustees sale here in Washington, a non-judicial foreclosure state) has nothing to do with the solvency of the borrower (in the general sense), merely did they make the payments specified in the promissory note and security instrument (mortgage, Deed of Trust here in WA, Trust Deed, etc, depending on your particular state).

      Also, as a secured debt, in general, a mortgage has a high priority in a bankruptcy, unlike unsecured debts (credit cards, for example). That’s one reason why a mortgage can be had (even today) at 6% while credit cards will loan you money at 14-39%.

      1. Please, please, please. Let’s not get the feds any more involved in housing than they already are. Do you really think the feds will adopt the most sensible state policies on this issue? My experience tells me that they’ll take on the most ridiculous ones. But at least things we’ll be equally bad, then – no privileged states.

  5. Overall a good article, but I have to point out that, per the heat map provided, there doesn’t seem to be a lot of overlap on the “easy foreclosure laws” front. Georgia, Michigan, Utah, and until just within the last year or two Arizona and California are all easy – moderate states to foreclose in, while Florida, Ohio, New York, Connecticut, & several others are notoriously “difficult”. There are dark and light states on that map on both sides of the foreclosure law spectrum.

  6. I know how much it sucks to argue in a foreign language. But these guys were teeing her up and she still spoke in such a strident tone that I wanted to disagree even though I actually agreed with most everything she said.

  7. Myth 1: In order for the economy to recover, housing prices have to reach pre-recession levels.

    Who ever claimed this?

    1. I mean who that allegedly knows something about the issue.

      1. “I mean who that allegedly knows something about the issue.”

        So, no one in the Obama administration, right?

        1. Most likely the national association of realtors claimed this. Obviously they’re wrong for the entire economy, but I would also think they are wrong for their own benefit as well. If prices were allowed to drop, they would sell more homes and get more (albeit smaller) commissions. Houses are staying on the market forever now, that’s got to be a pain in the ass for sellers and realtors. what they most likely want is rising prices, meaning rising investment value, and cheap credit, leading to more more volume at higher prices. But those days are gone my friends. I’m glad they finally let that homebuyer tax credit expire.

          1. ahem, follow the money…
            hint: who owns the property once it goes to foreclosure?
            a)National Association of Realtors
            b)Former Mortgage Payer
            c)Bawney Fwank
            d)Mortgage Holder

    2. Who ever claimed this?

      Just about everyone in Congress.

      1. As well as the Federal Reserve, that seems to believe that its job is to keep inflated asset prices…uh, inflated.
        It is astounding that….well, maybe not – the Federal Reserve believes that the Sun shines out the as* of Goldman Sachs, and that lending isn’t everything, its the only thing.

        http://www.kansascityfed.org/p……12.09.pdf

        Remember, in Fed speak ‘stability’ is translated as keeping assets, particularly real estate owned by banks, plausibly at high valuations so that extend and pretend can continue. The gubermint pretends the economy is OK, The Fed pretends it knows what it is doing, and NAR gets to say, “NOW IS A GOOD TIME TO BUY A HOUSE!!!!”

  8. This is true as far as it goes, but what went wrong with the housing market was not primarily the market for housing (buildings), but the market for land. It was land prices that increased at double digit rates year after year, until the bubble finally burst. The states where the problem is concentrated are basically states with low property tax (like California, with Proposition 13). Low property taxes mean low holding costs for land, and therefore contribute to speculative frenzies in land prices. If high income and sales taxes were replaced by land value taxation, we wouldn’t have land price bubbles in the first place.

    1. “The states where the problem is concentrated are basically states with low property tax (like California, with Proposition 13).”

      Wanna try that again? Prop 13 taxes only apply to buildings *NOT* sold.
      Once they’re sold, the tax resets at current valuation.
      And given the valuation is as high as it is, CA property tax isn’t “low”.

    2. I know this is only an isolated datum, but on Long Island in New York property taxes are not especially low. Some might say they’re quite high. In 2005, I sold a home that was purchased for $40,000 in 1974 for $405,000. It was a three-bedroom home on a 7,500 sq. ft. lot, and in an average neighborhood. This was not an unusual price for similar homes in the area. At that time, our property tax bill was approximately $9,000 per year.

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    1. I speak Turkish, never thought it’d come in handy to read random spam though ..

  10. If gas prices go up, it’s a national emergency, and “something must be done” to prevent people from paying an extra $20 a month at the pump.

    If house prices go down, it’s a national emergency, and “something must be done” to prevent people from paying an hundreds less a month or tens of thousands less up front for shelter.

    1. From Shermer:
      1) If you charge more than a competitor, you’re “gouging”.
      2) If you charge less than a competitor, you’re “dumping”.
      3) If you charge the same as a competitor, you’re “colluding”.
      4) If you don’t have competitors, you’re a “monopoly”.
      So a crises or crime is always at hand.

      1. And if you go bankrupt, then without a bailout, economic apocalypse will quickly follow.

  11. Another reason is that the homes that were built in many of the areas with the biggest growth got a huge blow from a loss of immigrants (legal and otherwise,) and a combined lack of good jobs in those areas with higher gas prices. Those commuter communities in Arizona, Nevada, and California just died when gas hit $3 and $4/gallon, and that’s not going to avoid causing problems again. When people couldn’t afford driving to jobs they didn’t like to support homes too far away and in places the owners decided they didn’t like anyway, walking away was a sane option. Scold away, but there’s no morality in sticking to a bad decision. Or a series of them.

    1. “Scold away, but there’s no morality in sticking to a bad decision.”

      Except that slight matter of ‘your word’.

      1. You don’t give “your word” when you get a mortgage. You sign a contract, just like any other business deal, with the penalties for violation outlined clearly. In many of these states that banks chose to lend in, their were limitations on assets banks had recourse to in foreclosure proceedings. Banks, staffed with financial and legal professionals, drew up the contract containing that option, which they undervalued and sold, and borrowers are free to exercise it.

        1. “In many of these states that banks chose to lend in, their were limitations on assets banks had recourse to in foreclosure proceedings. Banks, staffed with financial and legal professionals, drew up the contract containing that option, which they undervalued and sold, and borrowers are free to exercise it.”
          In which case, I have no problem at all.

  12. “Furthermore, there is a very close relationship between the timing of the nationwide drop in housing prices and the rise in the foreclosure rate. …It supports the idea of voluntary homeowner default.”

    Actually it supports the idea that you are less likely to be able to sell and cover the mortgage when prices have dropped rather than strategic default. Especially in a cycle where there was little equity down to absorb the difference in current price and loan balance.

    1. bingo, when i was in the business it was drilled into are heads 25% and 36% with 20% down.
      25% = monthly income available for mortgage/rent.
      36% = total of all monthly liabilities and mortgage/rent.
      20% = 20% down of purchase price of house.
      unless it was an FHA/VA deal, if the above percentages weren’t there you told the perspective buyers, “Sorry”.

  13. We need a foreclosure moratorium to help those people drowning in debt who have had to default on their mortgages.

    No, but the legal status of some foreclosures is a little more iffy, and the delinquent borrowers often struggle to get a modification from certain banks like BofA. Part of the issue is that servicers are in over their heads; they’d been cutting costs in the boom years only to realize that all of a sudden they need a ton of temporary staff and completely new infrastructure. And then you have the issue that around half of modified loans redefault. Quickly.

    Some banks (implicitly) want to speed up proceedings because they can’t track modification documentation. Some want to slow it down because they don’t have the capacity to fix up foreclosed homes and sell them at auction without a steep discount (which banks never accept, so they just wind up with REO inventory). Many borrowers are in financial trouble due to regional unemployment, some just don’t like the monthly hit to their wealth for not exercising the foreclosure option. Non-portfolio lenders (JPM via WaMu, BofA via Countrywide, i-banks via their own wunderkinder) don’t have all the documentation, and the finality of such foreclosures is in question in some states. The regulators have never had a clue. Going forward, there was no Option ARM bomb because interest rates are low and the resets were largely manageable, but no one can say the same 5 years out. Such borrowers can’t refi without equity, and even if banks were to let them it would up their monthly payment.

    This status quo is pretty depressing, so I sympathize a bit with people claiming we Have To Do Something. Feels bad, man.

    Full disclosure: I worked at Wachovia/Wells Fargo from 2007-2010. I was part of the large team that came up with the pilot loan modification programs, specifically the group determining optimum principal/rate forgiveness. Make of that what you will.

    Easy foreclosure rules increase the option value of default and so more borrowers at the margin do it.

    I just like highlighting anything that looks at foreclosure as the exercise of an option. This is absolutely true. Homeowners receive the option to put the mortgage back to the lender at an exercise cost that includes often intangible costs like relocation pains, social stigma and poor credit. For those in high-default neighborhoods of high-default states who don’t intend to buy again soon, this cost is minimal, and so the choice of whether to exercise your option when you’re 30% underwater is pretty clear.

  14. So for the economy to recover, housing has to be even more unaffordable.

    Does this same logic work with gas prices? Do higher gas prices lead to economic recovery?

  15. the real question is, would you hit it? And I say, yes….like the hammer of Thor! 🙂

  16. I usually agree with the conclusions Ms. de Rugy draws in her articles (including this one), but her evidence is almost never compelling. For example:

    –“as the chart below shows, for most of American history housing prices grew at a relatively slow rate”

    So you would expect a chart or table that shows “most of American history”, right? But she instead shows a graph since 1987. Wouldn’t it be more relevant to see what housing prices did BEFORE the “government policies that encouraged homeownership” kicked in?

    –“On this chart we see the striking relationship between the decline in housing prices and the increase in foreclosure rates. It supports the idea of voluntary homeowner default.”

    Isn’t this the classic “correlation = causation” fallacy? Sure, defaults rose and housing prices fell at the same time. But couldn’t that be due to a common third factor, such as the recession? It is very reasonable to think an economic downturn would both decrease housing prices (and the prices of other fixed capital assets like office buildings, business equipment, etc), and cause defaults to increase (as people lose their jobs and paychecks, and are unable to make mortgage payments).

    –The graph of new foreclosures is not adjusted in any way for the size of the state.

    So it’s no surprise that high-population states like NY and SC are at the top of the foreclosure list, and low-population states/districts like VT, DC, ND, SD are at the bottom. These numbers are almost meaningless without a useful denominator like “per population” or “per existing # of housing units in the state”. For example, NY looks to have about 2,900 foreclosures, and WY 100. The population of NY is around 19 million, and WY 0.5 million. When adjusted for population, NY has about one foreclosure per 7,000 residents, and WY has one per 5,000. So NY is still higher, but there is no reason for me to believe that one per 7,000 is a “crisis” and one per 5,000 is no problem.

    1. Sorry, last two sentences should be: “When adjusted for population, NY has about one foreclosure per 5,000 residents, and WY has one per 7,000. So NY is still higher, but there is no reason for me to believe that one per 5,000 is a “crisis” and one per 7,000 is no problem.

      1. Nope, I had it right the first time. When adjusted, WY has one foreclosure per 5,000 residents, which is actually HIGHER than NY’s rate of one per 7,000. So the graph is a little misleading.

  17. I have one comment run don’t walk. I wouldn’t buy a house at these prices or even the prices of 15yrs ago because THEY were too inflated. I know the value of quality and a dollar. They can keep their overprice dumps and watch who loses in the end. It isn’t us staying away.

  18. I dont quite know what the point of this article is. 1) Who says prices must return to pre-recession levels? If they do you will be getting ravaged by hyper inflation. 2)I agree that there is a moral hazard in forclosures. 3) There is no forclosure crisis in WY, ND, and SD? How comforting for the rest of us who live near civilization. If this article was meant as some kind of argument that we did not have or are not having a severe housing crisis, it falls woefully short. It does not even adress the major issue of the wave of middle class baby boomers who’s main retirement vihicle has had its equity gutted. Or that millions of boomers will be looking to unload their McMansions in the next few years. I suppose that it’s a happy spin that buyers will be able to pick up these McMansions for 50% of the peak price before all this clears.

  19. Housing deflation will have a nice offsetting effect to commodity inflation. That in combination with a decimation of the public sector and entitlements will cause buying behaviors to correct in a good way:

    1. People will rent in the first 10+ years of their careers as they should to keep mobile and find their niche before settling down.

    2. People will really think about what they need vs what they want in the way of food and liesure.

    3. People who are former welfare queens and union slackers will have to get real jobs and do them well to build actual careers and retirements.

    There Ain’t No Free Lunch, there never was, and I for one am enjoying the caterwalling from the spoiled left as they face actual competition and accountability. I laughed my ass off when I heard a group of AFT protesters burst into tears when the Wisc. bill passed the first hurdle. Whiny dipshit parasites.

  20. CA et al tried to gentrify the entire state via zoning. IOW, they built too many homes that only the top 20% can afford, and few homes that the bottom 80% can afford. People won’t pay for what they can’t afford. The math doesn’t work.

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